More than 400 equity mutual fund (MF) schemes with the dividend option may lose favour among investors following the Union Budget proposal to levy the dividend distribution tax (DDT) at 10 per cent.

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Put together, these sets of schemes have assets under management (AUM) at Rs 1.5 trillion, which is a fifth of the industry's equity assets. These exclude balanced schemes with the dividend option, which too have come under the tax net.

The move to tax dividend-paying schemes is to bring tax parity.

Union Finance Minister Arun Jaitley said the move was to provide a level-playing field across growth-oriented funds and dividend-distributing funds.

Dividend-paying schemes are designed for investors who want a regular income through dividends, which are paid either monthly, or quarterly, or yearly. Industry executives say such schemes are taken mainly by high-networth individuals (HNIs), whose investment corpus is more than Rs 500,000.

Industry players fear the 10 per cent tax will take the sheen off dividend plans.

They add there will be a rapid shift from dividend-oriented schemes to growth-oriented schemes, in which the dividend is ploughed back into stocks.

According to Kaustubh Belapurkar, director (fund research), Morningstar India: “The move to bring 10 per cent DDT on dividend options of equity funds is likely to impact flows into such schemes. I believe growth-oriented schemes are at an advantage against dividend schemes as long-term capital gains below Rs 100,000 are exempt from taxes."

Industry experts say the new tax will reduce mis-selling.

“The biggest mistakes are made when something which embodies risk is presented as low-risk. The tax on dividends will surely preclude one such misrepresented carrot. Paying a monthly dividend in equity funds is a misrepresentation of risks because the underlying principle is susceptible to wild swings. But the regular income lulls people into believing it is a steady product and by implication low-risk. Mis-selling is aggravated when this equity product is offered to fixed-deposit investors in the higher tax brackets, citing tax-free dividends. This will no longer be the case now," says Aashish Somaiyaa, managing director and chief executive officer, Motilal Oswal AMC.

Somaiyaa adds due to mis-selling, the average balanced fund size has grown to Rs 51 billion compared to an average equity large-cap fund at Rs 21 billion.

Legal experts say the DDT, instead of ensuring a level-playing field, now puts dividend-option schemes in a disadvantageous situation.

“The 10 per cent tax on dividend options of equity funds is to bring them on a par with growth schemes. In fact, dividend schemes are now slightly disadvantaged as distinct from growth schemes as the long-term capital gains tax below Rs 100,000 is exempt from tax," says Amarjeet Singh, Partner, Tax & Regulatory Services, KPMG in India.

Fund managers say if investors shift to parent growth schemes, which is expected, dividend plans may become redundant. However, some investors who want a regular income may continue to opt for the dividend option despite the higher tax.